Ten Rules for Pairs Trading

CaptureTen Rules for pairs trading:

1. The higher the correlation, measured by thinkorswim, the greater the likelihood of success.

2. Lower or non correlated pairs trades also work, but they must be attended to more closely; for they are essentially speculative.

3. At any given time a correlation can begin to breakdown. At such moments, it is difficult to determine whether the relation is indeed changing or the correlated pair is temporarily mis-priced.

4. The leverage of futures provides opportunities; even noise can be profitable. But it is difficult to determine whether the initial movements are simply noise or indicative of a short-term trend.

5. The ratio of winners to losers that I presumed prior to my tests has been confirmed. Because the probabilities seem to be on the side of the trader with highly correlated pairs, managing winners becomes very important. Ideally, one should be more patient with winners than losers.

6. Expect challenging trades to occur with some regularity though not frequently.

7. Every trade has the potential to become challenging.

8. I consult the following when making the trades:

A. The relative price action.

B. The correlation.

C. The volume and liquidity of the contracts.

D. The 4 hour and daily charts of the respective pairs.

E. The large and small player volume as measured by Effective Volume.

9. I like to trade in the evening and late mornings.

10. When I have a challenging position, I look at the trade anew and ask: Would I place an identical trade at the current prices? If the answer is yes, there is no reason to close the trade.cyborg

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